This blog is designed to record the investment journey of a UK based small investor. I hope to make a modest contribution to the collective wealth of investing knowledge made freely available to ordinary people. I am the author of four books [see sidebar and books tab]

Tuesday, 14 February 2017

Work Out Your Retirement Figure

I drifted into retirement at the age of 55 yrs. The partnership I worked in on the edge of Dartmoor (hence covers for my books) wound down and we all went our separate ways.

After a short break, I looked at my savings, investments and pension pot and realised I could probably make a couple of changes to my portfolio and get along just fine on the income I could generate with the option to convert my pension at a later date to income drawdown.

Basically, the amount I needed to retire on was not so much about a vague idea of amassing a fortune - say half a million pounds - but more a case of being able to generate sufficient income from my assets to replace earned income.

If I possessed a little more foresight in my earlier years, I might have put in place a planned strategy for early retirement. Here are a few thoughts on how younger workers in their 20s, 30s and 40s could start to work out a rough figure to aim for their retirement.

The Process

There are two basic questions to be addressed - what level of income do I need when retired and secondly, what level of savings will be needed to provide that income?

So, although this is not a precise science and each individuals circumstances and preferences will vary, here is the outline of a few basic steps towards working out a figure.

1. Set a target date for your ideal retirement - it may need to change as the calculations unfold.

2. If you know what income you need fine, otherwise take your current annual net income and deduct 20% as this is the average work-related expense you will not have to spend when retired. So, if your take home pay is £30,000 this target figure would be £24,000.

3. If you have a works and/or personal pension or SIPP, get a projection of the annual amount(s) to be paid and deduct from the above figure.

4. Multiply the remaining sum by 25 to provide you with a ballpark capital sum needed to generate the remaining income.

Therefore if the replacement income figure after deducting works pensions was £12,000, the lump sum needed to generate this annual income would be £300,000 (£12K x 25). This is based on a reasonably sustainable return of 4% p.a. from the investments.

If you intend to bridge the gap between early retirement and state pension, for example 10 yrs from age 57 to 67, it may be an option to use a lower multiplier figure of say x 18 (rather than x 25) which would obviously reduce the lump sum figure - in the above example from £300K to £216K. The income taken from the lower sum would be nearer 6% p.a. which would be less sustainable long term but certainly a feasible option over 10 yrs.

5. Once you have settled on a final figure and you know the number of years from now to your retirement date, work out what level of savings from your current income would be needed to reach this figure.

There are many online calculators available - I use Candid Money . To generate £300,000 in the above example would take just over 20 yrs saving at 20% of salary in an investment ISA assuming 6% average return.

If you are saving via a sipp or the new lifetime ISA remember to factor in the HMRC tax credits to your contributions.

6. If your retirement date is close to your state pension age of 66 or 67, remember to factor this additional income into the calculations, for example the new flat rate pensions are ~£8,000 p.a. . In the above example, the £12,000 therefore reduces to just £4,000 and the lump sum required comes down from £300K to £100K.

The Decision

Having worked your way through these steps and maybe played around with a number of different calculations, it is time to make a decision.

Is it worth cutting back on all but essentials, living frugally and increasing the savings rate to 40% or 50% to bring forward the retirement date by maybe 10 yrs like my fellow blogger RIT has recently achieved?

Maybe you could manage on less than current salary minus 20%.

Once you have all the information, settled on your ideal retirement date and worked through the various calculations, you can make an informed choice. Without doing the above, you are not really in control of two important elements - how early you can retire and how much you will receive.

I suspect, like me, most people will be more focussed on the present and possibly just hope things will work out for the best down the line.

Feel free to comment below if you have some thoughts on saving towards retirement

7 comments:

I think you need to distinguish between before tax (and NI) income, post tax income, and spending. Investment income is taxed less aggressively than employment income, no NI for example, and tax free pension lump sums make it easier.

Exclude mortgage repayments from your retirement spending, as you are likely to have paid off your mortgage.

If you have a family, spending at 65 is likely to be very different to that at 45.

Also take a look at Bogleheads Variable Percentage Withdrawal spreadsheet - https://www.bogleheads.org/wiki/Variable_percentage_withdrawal

The idea is to use up all your pension by the time you die (default settings are for age 99 so not unreasonable) and based on your stock/bond allocation it tells you what percentage you can withdraw each year. If you make it to 99 then take out 100% and hope your grandchildren will look after you (your kids will be too old). You can backtest it with US data and it shows a pretty steady income stream in the very worst markets.

My current plant to retire by 57 is to: 1) Pay off the mortgage. 2) Have a "cost of living" pot of money invested in trackers 60/40 stock/bond and withdraw 3.5% in year 1, then in year 2 take year 1 + inflation and then repeat until I die (although if the markets do tank I will probably withdraw 95% of the previous year which should not impact my life too much). 3) Have a "enjoy myself" pot and use the above VPW to withdraw x% of the pot each year and exhaust it by the time I am 99. Starting at 57 with a 80/20 stock/bond I can take 5% and by the time I am 67 it is 5.6%.

It is possible I could live past 99, but it so unlikely and I doubt I will be doing very much as I will be plugged into the matrix. In any case, the chances are I will have a big pot of money to buy an annuity/upload my consciousness to the cloud.

For the cost of living pot which includes my wife's small final salary pension aged 60 it's about 16,000/year and about 20,000/year for the enjoy myself pot.

I need to do more budgeting to see how realistic that is as currently we spend nearly double that but have a mortgage and two school aged children with sports clubs/school clubs/music lessons/gadgets etc and they are not getting cheaper.

Those who are not close to retirement might find it hard to know what income they would require.

One way around this is to make use of ONS statistics. These provide the median incomes of a working household and a retired household.Consider using these as targets to aim for - if most people can survive on these incomes then so can you.

https://www.ons.gov.uk/peoplepopulationandcommunity/personalandhouseholdfinances/incomeandwealth/bulletins/nowcastinghouseholdincomeintheuk/2015-10-28 (NB disposable income is net of income tax, NICs and council tax). Add back the council tax and work out the gross income (excluding NICs).

Use salary calculator to do this https://www.thesalarycalculator.co.uk/lifestyle.php

Assume that you will use pension drawdown (you can buy an annuity with some of it to cover the basics if you want). Be very careful with the % drawdown figure.

If you intend to have your drawdown income rise in line with cpi each year without fail then around 3.75% might be tops.That means you need to amass a pension pot of median household income + council tax x 100/3.75.

If you don't want rising income EVERY year then you can stress your pot more, perhaos 4.5%-5%pa. Read Guyton & Klinger's Decision rules paper very carefully for a rules based approach that takes the emotion out of it.

http://www.bobneiman.com/NWM_Pages/Decision%20Rules%20%26%20Maximum%20Initial%20Withdrawal%20Rates%20-%20Guyton%202006.pdfVicarage is right to say you have to factor in income tax NICs and your HMRC personal allowance etc.E.g. for the 2018-19 tax year with a personal allowance of £11850, a withdrawal rate of 3.75% from a pension pot of c. A 5% drawdown gives £1685 per month net income after you have handed over £780 to HMRC. You need to know your income required after tax to work backwards to the gross annual income needed. Then apply a multiplier based on your chosen withdrawal rate (e.g. 4% = 25x)

For those in the decade before retirement, re-calculate the pot required each year based on the ONS household income figs. The idea is that as you will create a glidepath for yourself and know whether or not you are on target.

THat's the top down approach.

At the same time, do an annual bottom up cost of living tally. Remember that food electricity and gas go up more than cpi. Smile that you won't have to pay a mortgage or fork out for a season ticket. But frown because you might have the heating on more in winter and your car insurance premiums will rise with age.

If you create a pension pot to deliver natural income then you don't have to worry so much about equity market volatility. You will also be able to see your future income rising each year as you head towards target. By building up say 3 years of income in cash you can ride out stock market setbacks without having to sell.

Apologies for going on somewhat, I hope you'll find these two approaches when combined will give you a very good idea of how much you personally need to retire and, given that, when you will be able to retire.